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Why Fannie and Freddie Won't Take The Deal

Hedge funds have a complicated solution to winding down Fannie Mae and Freddie Mac. Here's the plan in five steps.

What should be made of Fannie Mae(OTC:FNMA) and Freddie Mac(OTC:FMCC)? One hedge fund has a suggestion.

Fairholme Funds, led by Bruce Berkowitz, has a big plan to wind down the GSEs and start his own private mortgage insurers.

Here's the plan in five steps:

Fannie Mae and Freddie Mac stop writing new insurance at a defined date in the future, and a new private insurance company starts writing those policies. The presentation names June 30, 2014, as an example date.

The existing assets of Fannie Mae and Freddie Mac are determined to be "legacy" assets, and those assets stay there.

The proceeds from the "legacy" assets are paid to the common stockholders of Fannie and Freddie as well as the U.S. Treasury to pay off its preferred stock. (The U.S. Treasury owns warrants giving it 79.9% of Fannie and Freddie's common shares, so it would continue to participate in the profits even after its preferred shares are repaid.)

The new insurance company will write private mortgage insurance policies as state-regulated companies. It will be financed with preferred stock from Fannie and Freddie worth $34.6 billion and $17.3 billion from a rights offering.

Fannie and Freddie would not compete with the new insurance company, and the federal government would not give the new insurance company any backing. Fannie and Freddie would eventually see their balance sheet go to zero as assets and liabilities are retired. The new, private company essentially takes their place in mortgage insurance.

When you boil it all down, you realize what a deal this is for Berkowitz and his investors.

Berkowitz would get paid off at par value to turn his preferred stock at Fannie and Freddie into preferred stock at the new insurance company. And the new insurance company, unlike Fannie or Freddie, would be able to eventually pay dividends to its owners.

Politics remain a problemThere are still a number of problems with the plan. First, it assumes that Congress and the FHFA actually care to wind down Fannie or Freddie. While an individual congressperson may support that sentiment, the U.S. government will make billions of dollars per year keeping Fannie and Freddie as they are right now. Will the government really give up control of the government-sponsored entities and all of their earnings power that it took in 2011?

Secondly, as the new insurance company would presumably write trillions of dollars in mortgage insurance, it will be a very big company -- just as "too big to fail" as Fannie and Freddie were in 2009. Cue the discussion about "privatizing profits and socializing losses."

The Foolish bottom lineBerkowitz's plan requires the government to give up the "net sweep agreement" that currently sends all Fannie and Freddie profits to the U.S. Treasury. It's the key to the puzzle, but it's really the same problem that Fannie and Freddie shareholders have been fighting all along.

The only difference is that, with this offer, Berkowitz will help start a new private insurance company. I think it's obvious by now that the government would prefer to keep its cash cow than create a market for privately financed mortgage insurance.

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